Bank Competition: Measurement,Decision‐Making,and Risk‐Taking

This paper investigates whether greater competition increases or decreases individual bank and banking system risk. Using a new text‐based measure of competition, and an instrumental variables analysis that exploits exogenous variation in bank deregulation, we provide robust evidence that greater competition increases both individual bank risk and a bank's contribution to system‐wide risk. Specifically, we find that higher competition is associated with lower underwriting standards, less timely loan loss recognition, and a shift toward noninterest revenue. Further, we find that higher competition is associated with higher stand‐alone risk of individual banks, greater sensitivity of a bank's downside equity risk to system‐wide distress, and a greater contribution by individual banks to downside risk of the banking sector.     

Convergence and risk-return linkages across financial service firms

We examine the risk and return linkages across US commercial banks, securities firms, and life insurance companies during the 1991–2001 period. After controlling for changes in the broader stock market, interest rates, and foreign currency values, we find that return and risk interdependencies across these financial firms are significant and size-varying; larger institutions display stronger volatility transmission linkages, while smaller ones exhibit more prominent return-related linkages. The tighter link in risk among large financial institutions (FIs) suggests stronger convergence, employment of common models of risk measurement and risk management, and more intense inter-industry competition, particularly between large banks and large securities firms, compared to smaller institutions. Lack of risk spillover among smaller FIs confirms the intuition that they typically assume more localized and idiosyncratic risk. The co-movement of stock returns among smaller FIs has been helped by the effects of locally based factors, such as economic conditions and state regulations, on all such institutions, and a less diversified product set. Differences in spillover patterns between large and smaller institutions have implications on investment choices and mergers and acquisitions in the industry. Introduction of the Gramm-Leach-Bliley Act (1999) has had dissimilar effects on the riskiness of large versus smaller life insurance and securities firms, and an insignificant effect on commercial banks.     

Geographic Deregulation and Competition in the U.S. Banking Industry

We examine the effects of geographic deregulation on state‐level competition in U.S. banking markets over the period 1976‐2005. The empirical results confirm that the U.S. banks in general operated under monopolistic competition during the period examined. After partitioning the sample based on bank size we find that the market competition for large banks in Delaware, Oregon, and Rhode Island can be characterized as monopolistic while small banks in Arizona and Massachusetts seem to have operated under the conditions of perfect competition. The removal of geographic restrictions appears to have very limited and non‐uniform effect on state‐level competitive conduct. There is some evidence that the U.S. banking industry might have actually experienced a less competitive behavior in recent years due to increased market power of larger banks.     

Timeliness of Spread Implied Ratings

Rating agencies are known to be prudent in their approach to rating revisions, which results in delayed rating adjustments. For a large set of eurobonds we derive credit spread implied ratings and compare them with agency ratings. Our results indicate that spread implied ratings often anticipate the future movement of agency ratings and hence can help track credit risk in a more timely manner. This finding has important implications for risk managers in banks who, under the new Basel 2 regulations, have to rely more on credit ratings for capital allocation purposes, and for portfolio managers who face rating‐related investment restrictions.     

Financial services in an increasingly integrated global financial market

This paper discusses aspects of global financial services. As part of financial globalisation, financial institutions have evolved both nationally and internationally. FDI is becoming an important vehicle for multinational banks to enter developing countries. This in turn is changing the composition of trade in financial services. The experience of regional integration in Europe and the emergence of large multinational European banks signal a new era of global competition and consolidation of financial institutions. Home bias in international financial services is much less where financial integration is taking place. With financial globalisation, one should expect more diversification of ownership of multinational banks around the world, particularly when China and India are now able to have strategic investment in some of the key investment banks around the world. Financial globalisation requires stronger and more effective international institutions as a way of monitoring the activities of multinational financial institutions at both the national and international levels.     

Is universal banking justified? Evidence from bank underwriting of corporate bonds in Japan

We examine the extent to which universal banking in Japan creates conflicts of interest. We find that as banks enter the securities business, they discount the price of the corporate bonds they underwrite significantly in an effort to attract investors, thereby generating conflicts of interest that are harmful to issuers. Further, we find that close prior lending relationships between banks and their client issuers is the driving force behind such conflicts and that competition from investment houses limits but does not eliminate these conflicts. Our results contrast sharply with the evidence for the US, which largely shows a certification role for banks.     

Banks as Tax Planning Intermediaries

We provide the first large‐scale empirical evidence of banks functioning as tax planning intermediaries. We posit that some banks specialize in assisting corporate clients with tax planning. In this role, banks make use of their centrality in financial relationships; access to private information; and ability to structure, execute, and participate in tax planning transactions for clients. We measure bank‐client relationships using loan contracts and measure client tax planning using either the cash effective tax rate or the unrecognized tax benefit balance. Using a difference‐in‐differences design, we find that firms experience meaningful tax reductions when they begin a relationship with a bank whose existing clients engage in above‐median tax planning. The effects of pairing with such tax intermediary banks are concentrated in relationships with larger or longer maturity loans, clients with foreign income or greater credit risk, and when the bank is an industry specialist or has above‐median investment banking activities. Finally, we find that potential clients are more likely to choose tax intermediary banks than nontax intermediary banks, suggesting that tax intermediary banks benefit by attracting new business. Collectively, our results suggest that some banks act as tax planning intermediaries, a role beyond the traditional one of financial intermediary.     

Investment horizon,risk, and compensation in the banking industry

This paper examines the relation between the investment horizon of banks and their CEO compensation, and its consequences for risk and performance. We find that banks with short-term investment intensity pay more cash bonus, exhibit higher risk and perform more poorly than banks with longer-term investment intensity. This evidence is broadly consistent with the view that short-term means of compensation encouraged a short-term investment focus, which in turn led to both higher risk and resulted in poorer performance, culminating in the sub-prime crisis. The inverse risk-performance relation suggests pay schemes were incongruent with shareholders’ interest. Moreover, pay arrangements used in banks prior to the subprime crisis exposed banks to the ex-post settling up problem (the clawback problem).     

Banking Competition and Capital Ratios

Empirical studies provide evidence that bank capital ratios exceed regulatory requirements. But why do banks maintain capital levels above regulatory requirements? We use data for more than 2,600 banks from 10 European countries to test recent theories suggesting that competition incentivises banks to maintain higher capital ratios. These theories also predict that banks that engage in arm's length lending have lower capital ratios, and that shareholder rights and deposit insurance characteristics affect capital ratios. Consistent with these theories, our evidence robustly indicates that competition increases capital holdings. Banks that lend at arm's length exhibit lower capital ratios, whereas banks in countries with strong shareholder rights operate with higher capital ratios. We also show some evidence that generous deposit protection schemes that exclude non‐deposit creditors are associated with higher capital ratios. Our results have important policy implications. First, while the traditional view suggests imposing restrictions on bank activities in order to restrain competition, our analysis indicates the opposite, even after adjusting the regressions for risk‐taking. Second, weak shareholder rights undermine market forces that would otherwise encourage banks to hold higher capital ratios.     

Deposit market competition,wholesale funding,and bank risk

Empirical research on the effect of bank competition on bank risk has so far produced very inconclusive results. In this paper we revisit this long-standing debate and propose a new empirical approach that is concentrated on the relationship between deposit market competition and bank risk. This approach closely follows the traditional theoretical views of the competition and risk relationship and is focused on testing the classical moral hazard problem of the bank: deposit market competition raises the optimal risk choice of the bank by raising the costs of bank liabilities. Since banks can substitute between retail and wholesale funding, we relate deposit market competition to wholesale market conditions and examine their joint effect on the risk of bank assets. The analysis is based on a unique, comprehensive dataset, which combines retail deposit rate data with data on bank characteristics and data on local deposit market features for a sample of 589 US banks. Our results support the notion of a risk-enhancing effect of deposit market competition.